Historically Tight Credit Spreads Face a Test as Rates Rise

It will be a holiday-shortened trading week, with U.S. markets closed on Monday, September 7, for Labor Day. School has been back in session for a week, and the coming week looks important, with the CPI report due Friday, September 11—especially following last Friday’s much stronger-than-expected jobs report.

The ECB also meets on Thursday, September 10. Markets are pricing in a rate hike, with no further increases expected until February 2027. The press conference will likely provide important clues about what comes next.

Interest rates are rising in Europe, just as they are in the U.S., but credit spreads have not widened. This is an important reminder that the forces driving U.S. markets are also at work elsewhere.

Credit spreads also remain tight in Europe, despite rising interest rates. Conditions in European rates markets closely resemble those in the U.S., suggesting that what we are seeing here is part of a broader global pattern.

That may partly explain why rising interest rates have had little impact on equity markets so far. Despite higher rates in Europe, financial conditions still appear relatively easy, at least judging by sovereign spreads. The picture is similar in the U.S. But that does not mean conditions cannot change—or that a shift is not already underway.

One development stands out: U.S. AAA-rated corporate option-adjusted spreads (OAS) are widening, while high-yield spreads are still narrowing. The gap between the two is now the smallest it has been since 2007, with similarly narrow readings seen in the late 1990s.

With spreads already so tight in both Europe and the U.S., I question how much room remains for further narrowing. That matters for risk assets, especially if ECB rate hikes begin to tighten financial conditions and the Fed enters the equation as well.

With Friday’s CPI report approaching and the Fed meeting next week, credit spreads—and their implications for financial conditions—could draw greater attention from central banks.

-Mike

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Glossary by ChatGPT

AAA-rated corporate debt — Corporate bonds carrying the highest major credit rating, indicating exceptionally low expected default risk.

CPI — The Consumer Price Index, a widely followed measure of changes in consumer prices and inflation.

Credit spreads — The yield premium investors demand to hold credit-risky debt relative to a comparable lower-risk benchmark.

Financial conditions — The combined state of interest rates, credit spreads, asset prices, currencies, and other factors affecting access to financing.

High-yield spreads — The yield premium on below-investment-grade corporate debt relative to a lower-risk benchmark.

Option-adjusted spread (OAS) — A bond’s yield spread over a benchmark after adjusting for the value of embedded options.

Risk assets — Assets such as equities and lower-rated corporate bonds whose values are particularly sensitive to economic growth and investor risk appetite.

Sovereign spreads — Yield differences between government bonds, often reflecting relative credit, fiscal, liquidity, or market risks.

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